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Last Updated: Feb 18th, 2008 - 14:39:01 |
How to analyze income of a commercial real estate property
If you are analyzing income of a commercial property, you must remember that there are three basic methods to asses its value:
• Income approach,
• Sales-comparison approach and
• Cost approach
All these three approaches works well if you are analyzing investment on commercial property as lenders, appraisers, brokers, commercial real estate agents and investors. Due to the rapid increase in property values, the lack of comparables makes the sales-comparison approach fairly unreliable. Very little weight is given to the cost approach but the income approach involves the capitalization of income and therefore, the often-heard reference to capitalization rate or cap rate.
The principle of income approach is readily understood, yet it's often misapplied, even by the best professionals. Two ways to approach the analysis of the income is the direct capitalization approach and the annuity capitalization method, or discounted cash flow analysis.
If you opt for the Direct Capitalization method, the process involves the use of rates (i.e. cap rates) to capitalize the property's single-year net operating income (NOI) into a value estimate. The process is very easy: Value=Net Operating Income / Capitalization Rate. If the subject's net operating income is $100,000 per year (before debt service and depreciation) and if the cap rate is 10 percent, then the indicated value would be US$1,000,000. (US$100,000/0.10). A going-in (overall) capitalization (cap) rate is usually defined as the first year net operating income (NOI), (before capital items of tenant improvements and leasing commissions and debt service but after real estate taxes) divided by the purchase price.
However, the discounted cash flow analysis is an approach to valuation or appraisal of real property as determined by the amount of net income the property will produce over its remaining economic life. With this method, the market value is equal to the present worth of future net income.
So, if you are using the Direct Capitalization approach, your focus must be on the cap rates. Typically there is an inverse relationship between the sales price and the cap rate. The lower the sales price the higher the cap rate. The higher the sales price the lower the cap rate. If you are an investor or buyer of the commercial real estate, the higher the cap rate, the better for you. Remember that a mere 1 percent difference in the suggested cap rate could make a significant difference in the value estimate.
Finally, you must study and understand every facet of the income statement to assure the facility is operating on a stable basis. You should be in a position to answer the following before you go for an investment:
• Are the rents at market levels?
• Are physical and economic occupancies at their optimum levels?
• Are controllable expenses being managed properly?
Only when the answers to these questions are categorically "yes" and only when there are no other extenuating circumstances such as excess land or the pending impact of a new competitor, you can properly employ capitalization methods to determine value.
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